A pedestrian walks past an employment centre in London August 17, 2011. REUTERS/Suzanne Plunkett

LONDON (Reuters) - Britain’s unemployment rate dropped in July to its lowest since late last year, adding to speculation that the Bank of England may raise interest rates earlier than it has predicted.

The rate dipped to 7.7 percent in the three months ending in July from 7.8 percent previously, the Office for National Statistics said on Wednesday. That was its lowest since the September-November period in 2012.

The Bank has set the unemployment rates reaching 7 percent as a target in its decision about raising interest rates. It suggests this won’t be before the third quarter of 2016, but markets are betting it will be before this.

As a result, Wednesday’s release caused a jump in the pound to its strongest level against the dollar in seven months, while the difference between British and German government borrowing costs widened back to the highest level in three years.

British Prime Minister David Cameron welcomed the fall in unemployment. Two days earlier, his Chancellor, George Osborne, said the country’s economy was turning a corner having struggled to recover from the financial crisis.

“It’s another set of impressive figures,” said Investec economist Victoria Clarke. “It suggests the jobs market is recovering much like the broader economy. It reinforces our view that unemployment will come down to 7 percent more quickly than the Bank expects.”

Investors reckon joblessness will come down more quickly than the Bank does and have been pricing in the first rise in interest rates as soon as late 2014.

This risks a future confrontation between the Bank and the market.

The bets have led to rises in a range of market interest rates, including those that usually feed through to mortgages and other loans. Bank Governor Mark Carney has warned that the bank might provide more stimulus for the economy if Britain’s recovery is threatened.

The Bank believes the jobless rate will on the whole fall slowly as firms squeeze more out of their current staff as the economy recovers. Surveys of British services and manufacturing last month backed up that view as employment grew more slowly than overall activity.

But in another sign of surprising strength in Britain’s labour market, the number of people claiming jobless benefit - a narrower and timelier measure of unemployment - fell by 32,600 in August, much more than economists had expected.

July’s fall was also revised to show a drop of 36,300 - the steepest decline since June 1997.

PAY FALLS FURTHER BEHIND

Not all analysts see jobs improvement prompting earlier tightening.

“Although employment rose strongly, more timely evidence from the recent activity surveys suggests that firms are responding to higher demand more by boosting productivity than taking on new workers,” Martin Beck, economist at Capital Economics, said.

Forecasting the path of Britain’s unemployment rate has been complicated in recent years by older workers rejoining or remaining in the labour force, job cuts in the public sector and uncertainty about immigration levels.

The ONS said on Wednesday public-sector employment fell in the second quarter by 34,000 to 5.665 million.

The data also showed a record number of people working part-time because they could not find a full-time position.

Stronger productivity is unlikely to boost real wages anytime soon: the ONS said average weekly earnings growth including bonuses slowed to 1.1 percent in the three months ending in July compared with a year earlier. Excluding bonuses, pay grew 1.0 percent.

By contrast, inflation averaged 2.8 percent over the same period. Britain’s opposition Labour party has made the fall in living standards a centrepiece of its challenge to the government’s claims that its austerity helped the economy heal by keeping borrowing costs down.